TFA | Tax Planning after the Death of a Spouse

Income Tax Returns

Among the decisions a surviving spouse must make is the filing status for the year-of-death tax return. If John dies in 2017, his widow Jane must file a 2017 tax return in 2018, paying any tax due on John’s 2017 income as well as her own. Jane will be able to file a joint tax return for herself and John, unless she remarried in 2017. In many cases, the joint tax tables will result in a lower tax bill. If someone other than Jane is the executor of John’s estate, she should notify the executor of this decision, as the executor will also sign the joint return.

Another option is to use the “married filing separately” status. That might be advisable if John had substantial medical bills in 2017, leading to a larger deduction than would be available on a joint return. If the married filed separately filing status is used, the executor will sign John’s return.

Going forward, Jane probably will file singly, unless she remarries. Other options may be available if Jane supports a dependent child. The “qualifying widow” filing status may be used for two years after the year of death, if Jane is eligible under the following criteria:

• She is eligible to file a joint return for the year of John’s death;
• She does not remarry before the end of the same year;
• She has a child or stepchild for whom an exemption can be claimed;
• She provided a home for that child during the year, except for temporary absences; and
• She paid more than half the cost of keeping up that home.

A qualifying widow can use joint return tax rates and the highest standard deduction amount. Either Form 1040 or 1040A may be used, depending on income and certain other conditions. Even if Jane cannot file jointly or as a qualifying widow, she may be able to save tax by using the head of household filing status if she provides support for a relative and meets several other conditions.

Estate Taxes

In the above example, John’s assets become property of his estate at his death. If those assets generate more than $600 in annual gross income, IRS Form 1041, U.S. Income Tax Return for Estates and Trusts, must be filed. To file this form, a tax ID number for the estate, called an employer identification number (EIN), must be obtained. The due date of this return for calendar year estates and trusts is generally April 15 of the year after death; for fiscal year estates and trusts, the due date is the 15th day of the fourth month following the close of the tax year. For either deadline, an automatic 5 1/2-month filing extension is available.

In addition, some estates may have to file a federal estate tax return. This return, IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, is required only if the value of the decedent’s estate assets, plus any lifetime taxable gifts, exceeds the relevant estate tax exemption. That exemption for deaths in 2016 is $5.45 million, so few estates meet this requirement. Some states have lower exemption amounts, requiring a state estate tax return to be filed.

Even when an estate tax return does not need to be filed, surviving spouses might file one anyway. Filing Form 706 will allow the executor to elect portability of the deceased spousal unused exclusion (DSUE), commonly known as portability. With portability, a couple can effectively pass twice the exclusion amount—$10.9 million for deaths in 2016—to their heirs without owing estate tax and without extensive planning. Without a plan to use the portability election, asset shifting and trust creation while both spouses are alive might be necessary.

Portability’s Payoff

Assume that John dies in 2016 with total assets of $4.8 million. That is under the $5.45 million exemption amount, so John’s executor does not file Form 706 and therefore does not elect portability. Jane inherits everything from John, then dies a few years later, when the estate tax exemption has risen to $5.8 million. Holding all the marital assets, Jane dies with an $8 million estate, which passes to the couple’s children. Assuming the current 40% estate tax rate on nonexempt assets still applies, Jane’s estate would owe $880,000 in federal estate tax, reducing the net payout to the couple’s children. In order to avoid paying so much in estate tax, John and Jane might have to implement some expensive, sophisticated estate planning strategies. With portability available, however, such planning is not necessary.

If John’s executor elects portability on Form 706, and Jane dies in a year when the exemption amount is $5.8 million and neither spouse has made taxable gifts, Jane will have an $11.25 million federal estate tax exemption: her own $5.8 million plus $5.45 million from John. Jane can die with a much higher net worth without triggering federal estate tax.

In addition, portability might provide income tax advantages to a couple’s heirs. John can leave appreciated assets to Jane, who will inherit with a basis step-up to current value. Subsequently, Jane’s assets can pass to their children with another basis step-up at her death. This will enable the couple’s children to sell those assets without owing tax on the appreciation during John’s and Jane’s lifetimes, which might not be possible with an estate tax planning strategy based on trusts.

Despite the simplicity and low costs of electing portability, surviving spouses should be aware of potential drawbacks. If John leaves all of his assets to Jane, relying on portability for estate tax shelter, those assets may be exposed to Jane’s creditors in the future. Astute use of trusts may provide more protection. Electing portability might be only a first step in an overall wealth management and tax efficiency plan for a surviving spouse.

Company Benefits

If the deceased spouse was employed at the time of death, the surviving spouse should contact the employer. Chances are, some benefits will be due to the survivor. The same may be true if the deceased was no longer working but had previously been with the same employer for many years.

Generally, any such life insurance benefits will be received free of income tax, especially if the beneficiary is the surviving spouse. This may provide some immediate liquidity. The surviving spouse should always ask the company’s benefits administrator what options are available. The insurance policy’s terms could provide for an extended payout over many years or even for a lifelong annuity. Stretching out payments might be desirable, depending upon the surviving spouse’s circumstances, but such payouts might generate some income tax.

The same options might be available for payouts from insurance policies not provided as an employee benefit, and similar tax treatment may apply. Suppose, for example, Warren dies and leaves his wife Tara two homes in need of repair worth $1 million but little in the way of cash or marketable securities. Here, Tara probably should take the proceeds from any personally owned life insurance in a lump sum to generate cash immediately. Indeed, CPAs advising married couples should ascertain whether a cash crunch is possible and consider recommending the purchase of sufficient life insurance to address this potential problem.

Retirement Plans

Besides life insurance, company benefits available to a surviving spouse may include a retirement plan. Under federal law, surviving spouses are usually entitled to be the plan beneficiary. After the death of a spouse who had money in a 401(k) plan, the survivor should contact the plan administrator to see if this is the case and clear up any misunderstandings.

Assume that Emma has died and her wife Diane is the 401(k) beneficiary. Diane’s first steps should be to look at the account statements and learn what options are offered to beneficiaries. Had Emma made nondeductible contributions to the plan? The presence of after-tax money in the plan will allow some portion of future distributions to be untaxed. Diane should note the composition of the money in Emma’s account and keep careful records to determine how much tax she will owe on withdrawals. Diane can check her records against the numbers on Form 1099-R, which the plan administrator will use to report to the IRS when distributions are made.

In many cases, Diane would not be required to withdraw money from a company plan after Emma’s death. In that case, one option is to simply keep the money in the plan, where any growth will continue to be tax-deferred. Diane may prefer the creditor protection of an employer-sponsored plan, prefer specific products within the plan, or be reluctant to assume responsibility for managing the money in an IRA.

If money is needed before age 59½, Diane can withdraw funds from Emma’s retirement plan without owing the 10% early withdrawal penalty. Alternatively, if money is not needed immediately and required minimum distributions (RMD) have not yet begun, she can delay taking RMDs from a 401(k) until the year Emma would have been 70½. If RMDs have already begun, Diane must continue those withdrawals at least as rapidly.

Keeping the money in Emma’s company plan may have advantages, but Diane might prefer to roll the account balance to an IRA for greater control over the money. (Non-spouse beneficiaries do not have the IRA rollover option.) If she has not yet reached age 70½, RMDs will not be required after the rollover, even if Emma had started taking them. On the other hand, if she rolls over the inherited account to an IRA, she may owe the 10% penalty on subsequent distributions before age 59½, unless a penalty exception applies.

Some company plans require a beneficiary to immediately close the deceased’s account. If an IRA rollover is not elected, Diane will owe tax on the pretax dollars withdrawn, but the10% penalty on early distributions will not apply. Generally, electing to roll over the funds will simplify the process, avoid withholding, and reduce the risk of an unexpected taxable distribution.

Some surviving spouses should consider certain opportunities before an IRA rollover. Suppose, for instance, that Diane inherits Emma’s 401(k) and finds many shares of employer stock in the account. If those shares have appreciated sharply since they were acquired, Diane can take advantage of the net unrealized appreciation (NUA). To do so, Diane can move all of the employer stock into a taxable account while rolling over the balance to her own IRA. The withdrawal of the company shares will trigger income tax at ordinary tax rates, but the tax will be imposed only on the cost of those shares. The balance of the shares’ current value—the NUA—will not be taxed until a subsequent sale, and then favorable long-term capital gains tax rates will be applied to all the appreciation, pre- and possibly post-distribution from the company plan.

Another opportunity may exist if Emma was born before January 2, 1936. In this case, if Diane withdraws all the money in the company plan in one year, she may be able to use the “10-year averaging” method of calculating the resulting income tax. This often generates a much lower tax bill.

Inheriting an IRA

In many cases, a surviving spouse will inherit an IRA. As is the case with an inherited company retirement plan, the surviving spouse can withdraw all the money and pay the income tax due without incurring the 10% early withdrawal penalty, even if the survivor is younger than 59½.

If continued tax deferral in a traditional IRA is desired, a surviving spouse has several options. The distribution and taxation rules will depend on whether the deceased spouse had reached age 70½, when RMDs take effect. Suppose, for example, Gino is the sole beneficiary of his husband Frank’s IRA. Frank was 59 years old at his death, and Gino is now 55. Unlike a non-spouse beneficiary, Gino can transfer the assets into his own name, then wait until he reaches age 70½ to start RMDs. If Gino withdraws money from the IRA before age 59½, however, he will owe not only income tax but also the 10% penalty, unless he qualifies for a penalty exception.

Gino’s other option is to transfer the money in Frank’s IRA into an “inherited IRA” for his benefit. Then he can withdraw the assets without owing the 10% penalty. Gino can choose to withdraw all of the assets in the inherited IRA by December 31 of the fifth year after the year of Frank’s death.

If Gino wishes the inherited IRA to last longer than five years, he must begin distributions no later than December 31 of the year when Frank would have reached age 70½. Going forward, RMDs will be spread over Gino’s single life expectancy, determined by his age in the year of Frank’s death and recalculated annually.

If Frank were 71 and thus required to take RMDs, Gino could still transfer Frank’s IRA into his own name. If Frank had not taken RMDs for the year of death, however, Gino would have to withdraw enough money to fulfill the RMD. That year-of-death distribution would not trigger the early withdrawal penalty, even if Gino is 55, but any other withdrawals before Gino reaches age 59½ could be subject to it. Gino could still avoid the 10% penalty on early distributions by transferring Frank’s IRA to an inherited IRA. If necessary, he would have to fulfill any year-of-death RMD obligation, and going forward, he must take annual RMDs over a single life expectancy, beginning no later than December 31 of the year following Frank’s death. That life expectancy will be determined by Gino’s age in the year after Frank’s death, recalculated each year, or by Frank’s remaining life expectancy, whichever is longer. Once Gino reaches age 59½ and the early withdrawal penalty no longer applies, he may roll the inherited IRA into his own IRA, delaying additional RMDs until he reaches age 70½.

Similar options are available if Gino inherits a Roth IRA. Here, Frank’s age does not matter because Roth IRA owners never have RMDs. If Gino rolls Frank’s Roth IRA into his own Roth IRA, RMDs will not apply; all distributions will be tax-free after five years and age 59½. Treating the account as an inherited Roth IRA will trigger RMDs. RMDs still may not be as much of an issue, however, because distributions to a beneficiary from a Roth IRA generally avoid income tax as long as the five-year holding period has been met.

Moving On

Another major asset for a surviving spouse may be the couple’s principal residence. If the survivor wishes to move to another home after the death of a spouse, a sale might generate a capital gain, and a prime tax benefit can reduce or eliminate the tax on that gain. Under current law, home sellers can exclude up to $250,000 of housing profits from capital gains tax; this exclusion is as much as $500,000 for married couples who file a joint tax return. The seller must have owned the home and used it as a primary residence for at least two of the five years before the sale.

If a widow sells a primary home within two years of a spouse’s death, and the survivor has not remarried, the $500,000 tax exclusion may apply. The survivor can count any time when the deceased spouse owned the home and used it as a primary residence. This tax exclusion is not available if either spouse excluded gain from the sale of another home during the two years before the date of death.

No one likes to think about taxes during a time of grief. Fortunately, CPAs can help couples make a tax strategy beforehand, as well as ease the surviving spouse through the process of carrying out that strategy, thus lifting an emotional burden.